FIN%204260%20Chap%202%20SLIDES

FIN%204260%20Chap%202%20SLIDES - 1 Part I - Solvency,...

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Unformatted text preview: 1 Part I - Solvency, Liquidity & Financial Flexibility Chapter 1 Chapter 2 The Role of Working Capital Solvency, Liquidity & Financial Flexibility Chapter 3 Valuation Chapter 2 Agenda 2 Solvency, Liquidity & Financial Flexibility Be able to differentiate between solvency and liquidity ratios. Conduct an analysis of a firm’s liquidity. Sales Inv A/R Cash Cash Flow Timeline 3 The cash conver sion period is the time betwee n when The firm is a system of cash flows. These cash flows are unsynchronized and uncertain. Solvency v. Liquidity 4 A firm is solvent when its assets exceed its liabilities. This accounting measure is based on book, not market values. A firm is liquid when it can pay its expenses on time without undue cost. A firm has financial flexibility when it’s financial policies are consistent with 5 Short-Term Financial Condition Financial analysis is an assessment of a firm’s past, present, and future financial condition. In Chapter 1, we discussed financial statements. In this chapter, we will examine: Liquidity and solvency ratios. Solvency Measures 6 A firm has resources; how well it converts those resources into cash flows can be explained with ratio analysis. Ratio analysis is conducted from information on the firm’s financial statements. It can explain performance and how it has changed over time. 7 Sample Common-Size Bal. Sheet 8 Sample Common-Size Income St. Types of Ratios (see Appendix) 9 Liquidity (short-term solvency) Measures the firm’s ability to pay bills in the short-term. Important to short-term creditors (e.g. banks, suppliers). Leverage (long-term solvency) Measures the firm’s ability to pay long-term obligations. Important to long-term creditors (e.g. Solvency Measures 10 The following ratios are generally referred to as liquidity measures but, in fact, measure solvency. Current Ratio Quick Ratio Net Working Capital Net Liquid Balance & Working Capital Requirements Current Ratio 11 The Current Ratio indicates the degree of coverage provided to short-term (ST) creditors ifRatio assetsCurrent Assets were to be Current ST = Current Liabilities liquidated. Quick Ratio 12 Also known as the Acid-Test Ratio, the Quick Ratio excludes inventory in the numerator= sinceCurrent Assets - Inventory furthest inventory is the Quick Ratio Current Liabilities removed from cash. Net Working Capital 13 Net Working Capital is a dollar-based solvency measure. The larger the amount, the more solvent the firm. It is an absolute measure, not a relative measure, so it ignores scale and trends. Too much is considered a drag on financial WCR & NLB 14 Net Working Capital commingles operating and financial accounts. A variation separates Net Working Capital into two pieces: Working Capital Requirements (WCR) Operating CA – Operating CL Net Liquid Balance (NLB) Financial CA – Financial CL WCR & NLB 15 Working Capital Requirements (WCR) Net Working Capital Current Assets Minus Current Liabilities Current Assets Minus Current Liabilities Cash Accounts Payable Notes Payable Marketable S ecurities Notes Payable Accounts Receivable CMLTD Accounts Receivable CMLTD Inventory Accruals and Other Inventory Accruals and Other Cash Accounts Payable Marketable S ecurities Prepaids and Other Net Working Capital = WCR + NLB If positive, a portion of Current Assets is financed Prepaids and Other Net L iquid Balance (NLB) Current Assets Minus Current Liabilities Cash Accounts Payable Marketable S ecurities Notes Payable Accounts Receivable CMLTD Inventory Accruals and Other Prepaids and Other WCR & NLB / WCS/S 16 The level of WCR will change as sales expand and contract. WCR/S = WCR in relative terms (% of sales) During expansion, higher levels of WCR must be financed by: Drawing down NLB. Appropriate for seasonal sales increases. Adding to permanent working capital by What Is Liquidity? 17 Elements of liquidity include: Time The amount of time to convert an asset to cash. The Amount The quicker, the more liquid the firm. firm’s capacity to meet its ST obligations. Cost Assets can be quickly converted to cash with little/no cost. 18 Newer Approaches to Liquidity Traditional ratio analysis has proved an ineffective method for measuring and managing liquidity. Analysis should include: Amount and trend of internal cash flow. Aggregate available credit lines. Attractiveness of firm’s commercial paper, bonds, and stock to investors. Overall expertise of management. Statement of Cash Flows 19 The financial statement, the Statement of Cash Flows, provides information on cash receipts and disbursements during a specific time-frame. It is organized with cash flow data in three areas: Operations Includes transactions not included in the other The Statement of Cash Flows is most useful to external interested parties (banks, analysts, investors, etc.). It shows period to period data, but does not show daily variations in the cash cycle. 20 21 Cash Conversion Period (Cycle) We are concerned with the amount and timing of cash flows. We have to build and sell products, then get paid before we generate cash inflows. In the meantime, we have cash outflows for supplies and labor. This creates the Cash Conversion Period (CCP), the elapsed time between payment to suppliers and receipt of customer CCP and Activity Measures 22 Calculation of the Cash Conversion Period (CCP) relies on three activity measures. Activity measures indicate how efficiently the firm is using its assets. Days Inventory Held (DIH) Inventory Turnover Days Sales Outstanding (DSO) Receivables Turnover 23 Cash Conversion Period (CCP) Days Inventory Held (DIH) measures inventory management by calculating the average length of time inventory is Note: Using in stock before being sold. average inventory is a more accurate calculation. Days Inventory H eld = Inventory Cos of S t ales / 365 24 Cash Conversion Period (CCP) Days Sales Outstanding (DSO) measures credit / collections management by calculating the average time to collect from customers. Note: Using average receivables is a more accurate calculation. Days S ales Outs tanding = Receivables S ales / 365 25 Cash Conversion Period (CCP) Days Payables Outstanding (DPO) measures payables management by calculating the average time from inventory receipt to payment. Note: Using average payables is a more accurate calculation. Days Payables Outs tanding = Payables Cos of S t ales / 365 26 Cash Conversion Period (Cycle) Three Activity Measures explain the CCP: Days Sales Outstanding (DSO) Days Inventory Held (DIH) Days Payables Outstanding (DPO) CCP = [Production Cycle + Collection Cycle] – Payment Cycle 27 Cash Conversion Period (CCP) The CCP is generally positive; the longer the CCP the more financing is required for inventory and receivables. A lengthening cycle could signal liquidity issues. DIH DPO DS O Cash Conv. Current Liquidity Index 28 Liquidity includes both flow and stock. If cash from operations (flow) is not sufficient to cover current obligations, the firm needs to draw down other resources (stock). The index combines cash assets plus CFFO in the numerator and financial liabilities in the denominator. It is helpful in accessing cash flow Financial Flexibility 29 Financial Flexibility is related to a firm’s overall financial structure and if financial policies allow it enough flexibility to take advantage of unforeseen opportunities or survive unexpected difficulties. A flexible short-term financial policy would maintain a high level of current assets to sales, such as: Maintaining large cash balances. Maintaining large, but not excessive, inventory levels. Lambda 30 Lambda measures the likelihood that a firm will exhaust its liquid resources. Initial Liquid Reserve + Total Anticipated Net Cash Flow During Planning Horizon Lambda = -------------------------------------------------------------Uncertainty About the Net Cash Flow During Planning Horizon Lambda includes information about the volatility of expected cash flows. Historical data is used to calculate the denominator, using the standard deviation of the distribution of the firm’s expected net cash flow from operations. 31 How Much Liquidity Is Enough? Probability Probability LAMBDA LAMBDA In Left Tail 1.645 5.00% 2.053 2.00% 1.670 For example, a Lambda of 1.645 signals a 5% chance of running out of cash. In Left Tail 4.75% 2.108 1.75% 1.695 4.50% 2.170 1.50% 1.722 4.25% 2.241 1.25% 1.751 4.00% 2.326 1.00% 1.780 3.75% 2.432 0.75% 1.812 3.50% 2.576 0.50% 1.845 3.25% 2.808 0.25% 1.881 3.00% 2.879 0.20% 1.919 2.75% 2.969 0.15% 1.960 2.50% 3.291 0.10% 2.004 2.25% 3.291 0.05% 32 How Much Liquidity Is Enough? Using Lambda, and based on a firm’s unique circumstances, a firm need only maintain liquid reserves to meet unforeseen circumstances arising from a high degree of uncertainly regarding future cash flows. If the future is stable, there is a lesser need for liquid resources. Current Liquidity Index & 33 Lambda These two measures have a coverage component similar to the Current Ratio, but they also have a time (or flow) dimension as a result of including a measure of cash flow. 34 Risk Management Associates RMA publishes the Annual Statement Studies®, the industry standard for comparison of financial statement data. The studies report composite data on 680+ industries organized by the North American Industry Classification System (NAICS) derived from 190,000+ financial statements. Data broken down by industry with six 35 RMA Sample Common-Size BS 36 RMA Sample Common-Size IS RMA Sample Ratios 37 38 Appendix More on Ratios Liquidity Ratios 39 • • Measures the firm’s ability to pay bills in the short-term. Important to short-term creditors (e.g. banks, suppliers). Current Ratio = Current Assets ÷ Current Liabilities Quick Ratio = Current Assets - Inventory ÷ Current Liabilities Leverage Ratios 40 • Measures the firm’s ability to pay longterm obligations. • Important to long-term creditors (e.g. banks, bondholders). Total Debt Ratio = Total Debt ÷ Total Assets Debt-Equity Ratio = Total Debt ÷ Total Equity Turnover Ratios 41 • Measures how efficiently the firm is using assets to generate revenues. Inventory Turnover = Cost of Goods Sold ÷ Inventory Days Inventory = 365 Days ÷ Inventory Turnover Receivables Turnover = Sales ÷ Accounts Profitability Ratios 42 • Measures how profitable are the activities of the firm. Profit Margin = Net Income ÷ Sales Return on Assets (ROA) = Net Income ÷ Total Assets Market Value Ratios 43 • Measures market value indices for publicly traded companies. • Important to the investment community and credit markets Earnings Per Share (EPS) = Net Income ÷ Shares Outstanding ROE and Du Pont Analysis 44 • The difference between ROA and ROE is the use of financial leverage. • ROE can be ‘decomposed’ into it’s component parts to identify sources of strengths and weaknesses, as follows: Tax Burden Interest Burden Profit Margin Asset Turnover Leverage ...
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This note was uploaded on 11/10/2011 for the course ECON 4260 taught by Professor Victorwakeling during the Fall '11 term at Kennesaw.

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FIN%204260%20Chap%202%20SLIDES - 1 Part I - Solvency,...

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